Lehman Brothers & The Credit Crunch

Investment banking is inherently risky. Their over-riding purpose is to chase profit. To do so, they weigh up all of their possible opportunities and all of their possible outcomes in a hope of predicting their best gamble. In the face of the largest economic crash since the 1930s, investment opportunities were limited and the inherent flaws of every firm were brought to the fore. With the benefit of hindsight, it is clear that the ambitious decisions taken as part of Lehman Brothers’ operating model, were misguided. In accordance with Zingales (2008), their foray into subprime mortgaging with high leverage was their undoing.

Valukas (2010) stated that these choices together with the global recession brought the downfall of Lehman. Therefore, their demise was a consequence rather than a cause of the recession. The high leverage model left them exposed when the recession brought volatile conditions. Markets had already been on their way down for about a year before September 2008, Lehman exacerbated this so what was to come was worse than ever predicted. DOW Jones dropped 504 points as a result of Lehman’s bankruptcy and AIG were being forced into collapse as well. From this perspective, is it possible to call Lehman “too big to fail”? Perhaps it was, as another company’s existence was based on Lehman’s fortunes.

Businesses across the globe, both big and small, were directly affected by the shockwaves Lehman sent through the market. Either, there were indirect effects, such as money flow between firms halting or, direct problems for institutions who had a close working relationship with the bank. Bad debt securities that had passed onto the Fed, led to a week long period when they had to freeze redemptions as there were worries that their reserves couldn’t cope with the demand. The Fed also pumped excessive amounts of money into the economy for years afterwards in the form of a stimulus package from early 2009 to combat this. Their aim was to continue economic growth and ease the country out of a recession. Jordan (2010) and Whelan (2010) cite SunCal Cos as an example of firms that were directly affected by Lehman. A land developer and home builder based in California whose primary lender was Lehman, ran into debts in and around $230million. They managed to survive and are still operating today. However, outside USA, as far afield as Israel, a 3D graphics development company called Orad Hi-Tec Systems witnessed their stocks lose value, Tsipori (2010). Lehman was their largest shareholder and had been the underwriter for their IPO held in 1999. This was an obvious outcome.

However, it can be said that Lehman was a wakeup call to the banking sector. Richard Wolff, a journalist for The Guardian (2011) indicates that Europe felt threatened afterwards and the situation encouraged European countries to bail out their banks no matter the cost because they all believed it was better than the alternative. Lehman’s demise forced the market to be reassessed as there were clear problems, Zingales (2008). Market regulations were tightened in an attempt to increase transparency and tackle the complacency that can come with large, sustained profits.

Overall, I believe that the government followed the right course of action in the Lehman saga. A view reinforced with the discovery of corruption at the top and fraudulent records. The government had to show that they were prepared to let a bank fail. The government couldn’t afford to continue to act like a generous uncle. They had to re-incentivise a sector that had become negligent and refused to learn from the past - Enron, an American energy provider had applied an accounting gimmick similar to Repo 105 on their reports to transfer liability and subsequently failed in late 2001. In any case, Lehman was accepting bankruptcy. When they realised they were losing alarming sums of money from mortgages, instead of acting immediately and confronting their mistake head on, they hid it on their balance sheet in the hope that they could fool another bank into purchasing them and burdening them with debt. For Richard Fuld to initiate a very aggressive strategy for expansion, he maintained an even more passive one to stop bankruptcy.

This is the price of capitalism. Only the most organised, profitable and competitive companies survive and grow. Those who can’t make sense of the markets, embrace the competition or maintain the confidence of clients fail. And they deserve to fail!

Too Big To Fail?

The Wall Street Journal’s (2008) opinion was that Lehman Brothers was treated harshly by the Fed. The government always had the option to provide Lehman with a loan. The Federal Reserve had provided funds for mortgage providers Fannie Mae and Freddie Mac in the week previous to Lehman’s bankruptcy. They even supplied financial support to the insurers American International Group (AIG) the day following Lehman’s collapse. AIG were pressing for a loan and as the Lehman situation had distorted the market with more volatility, the government gave in reluctantly. Many commentators at the time claimed that the government and the Fed had no other option as the effects of AIG’s collapse would be all encompassing. These institutions were categorised by the government as “too big to fail”, whilst Lehman was not.

Graph taken from CNBC indicating AIG's falling share price and the amount of government it received and dates paid. Total was $137.8billion.

The US economy, like many other economies across the globe, is dependent upon the financial stability of certain institutions. These are viewed as integral parts of the economic system because of their connections to other banks, businesses and governments via contracts, loans and insurances, as defined by Joines (2010). If this select group were to fail, many others would crash along with them and in turn, the economy would struggle to ever recover. If their failure could be prevented, the government would step in and save them with the use of tax payers’ money. There were numerous financial institutions that gained this tag over the 2008-2009 period.

AIG was one such company given this tag because they guaranteed the debt of multiple corporations and many mortgages, which was customary as a result of the Subprime Mortgage Crisis. The New York Times newspaper that was published on September 16^th reflected that AIG’s failure would have caused significant write-downs in value of all the companies that had bonds insured by them. Roger Altman, a former Treasury officer, was reported in the New York Times, saying that because of the span of their reach, the world over was genuinely scared by the thought of AIG’s collapse. Andrew Clark, writing for The Guardian, highlighted these fears as UK retailers like Boots, Argos and Sainsbury’s would be devalued as AIG provided a substantial portion of their insurance.

Simultaneously in the UK, Northern Rock was undergoing a nationalisation themselves. Like Lehman, they too had got caught up in the mortgage market. One of their attractions was the 125% house value mortgages they were offering, which coincidentally accounted for the majority of their repossessions. The National Audit Office summarised that they were trying to maintain their assets of over £100billion, with short-term loans. Treasury announced they were backing Northern Rock, spread panic amongst depositors who began to “run the bank.”  Administration was considered as the search for buyers was unsuccessful but eventually the Treasury themselves took over Northern Rock because the potential “hardship” that the public could have faced was viewed as too extreme.

Why was Lehman not saved whilst AIG was? To this day there is a debate as to whether Lehman Brothers was too big to fail and whether it should, ultimately, have been bailed out. Opposition Democrats, like Christopher Dodd, criticised the government for being inconsistent. The Fed released a statement that they believed the market could handle the disruption caused by an investment bank, but held the view that AIG’s downfall would “lead to substantially higher borrowing costs and reduced household wealth”. It confirmed that the government were willing to let a bank fail, and what would stop them from doing the same again? It was a method of re-incentivising the sector again, to remain prudent, as there was no back-up plan otherwise. Vince Cable, Economics minister of the UK Liberal Democrat Party believed that “the US government had drawn a line in the sand.”

My own opinion is that the US government were trying to make an example of Lehman. It was a political decision. Votes were the main motive. Elections were scheduled a few months later and the Republican Party wanted to be re-elected. They couldn’t be shown to the public as being weak and bowing to the pressure that big business put on them (of course, this was undermined the following day). The taxpayers had already seen their own money that they worked hard for being used to rescue Fannie Mae and Freddie Mac and the government didn’t want to risk any more. Multi-million corporations had already gained a reputation for dismissing and belittling the every-man in the street. If the government were going to help a company, who as it would turn out were blatantly lying about their funds, it would create a very bad image for all involved.

The Final Days

From the Summer of 2008 onwards, Lehman could do very little to contest their slide into bankruptcy. A public offering launched on June 12^th could only garner $6billion, which was some way short of the aid Lehman needed. By the end of the week on Friday 12^th September, it had become clear to the public that this gradual decline had quickly developed into an overwhelming debt burden that Lehman could no longer handle themselves. At this point, the US Government called a meeting of the major Wall Street firms in an attempt to negotiate some sort of deal between all of the firms to save Lehman from collapse.

 

Lehman Brothers share price, taken from The Financial Times using Thomson Datastream. The stock price can be used to indicate firm performance.

It was always a possibility that the government themselves would come to the rescue themselves with a Federal Reserve bail-out if no agreement could be reached between Lehman and any other possible buyers. However, in this series of meetings across the 12^th to 14^th September, Henry Paulson, the US Secretary of the Treasury, stated and reiterated that a government loan would not be forthcoming. Valukas (2010) indicates that there were substantial moral objections within the Federal Reserve System and government as to the consequences of funding Lehman and it was also thought that the reported reserves within Lehman were too low to avoid collapse. Their perception was that any loan proposal would just stave off the inevitable.

 

The official Treasury photograph of Henry Paulson.

 

Initially there was interest in providing funds. Aidikoff, Uhl & Bakhtiari, have quoted the two main suitors on that weekend as Bank of America, who had bought Merill Lynch only months before, and Barclays Bank, UK. Andrew Clark reported a story for The Guardian newspaper that Bob Diamond, president of Barclays, had tried to get business tycoon Warren Buffett involved with the deal. Buffett had previously injected a $5billion cash boost into Goldman Sachs to ease them through the financial crisis. However, neither that deal nor Bank of America could finalise a take-over. Barclays buyout was dead in the water as it was blocked by the UK’s Financial Services Authority. In all reality, it was unlikely that any suitor would have took on the burden of Lehman as their problems were more far reaching than they disclosed.

As it was Lehman Brothers filed bankruptcy papers in the early hours of Monday, September 15^th 2008. The Wall Street Journal indicated in their issue the next day that liquidation was perhaps a no worse scenario than being bought and gutted by another bank. Once liquidation had begun, the bank was segregated into good and bad parts and put up for sale. The Guardian newspaper reported a week later that Barclays had purchased the North American division of Lehman’s business whilst Japanese brokers Nomura agreed a deal to take on Lehman’s equities across Europe, the Middle East and Pacific Asia.

Repo 105: Now You See It, Now You Don't

The debacle that Lehman Brothers found themselves in because of the subprime mortgage crisis led to a period of substantial losses that pushed the firm into the brink. A $2.8billion loss was announced on 9^th June in the 2^nd quarter report of 2008 which was the first reported loss during Fuld’s tenure as chairman.

The figures quoted on Lehman’s balance sheet were supposed assets of $700billion maintained with only a reported $25billion of equity. If these values were ever true, Lehman Bros had an extremely high leverage ratio of around 30-1, when commercial banks were restricted to a ratio of 15-1. In this position Lehman had to borrow billions of dollars each day to continue its operations. Whilst interest rates are low, a higher leverage ratio like that of Lehman’s can be profitable and manageable. When the decisions to undertake leverage were first made, the market reflected this and general conditions were favourable with a strong housing market and low interest rate, Zingales (2008). However, the financial markets changed, as we all know, and an unstable market with uncertain outcomes introduces instability in highly leveraged models. Risk managers within the company recognised that this leverage could become an insurmountable problem as the USA’s economy took a nosedive.

As a direct result of the 9^th June announcement, a process began to try to reduce the leverage ratio used by the firm. Some assets on the balance sheet are written down and whilst some others were reduced through fire-sales to improve overall liquidity. The publication of the financial figures consequently led to a reduced revenue stream and losses on hedge funds. All-in-all it seemed that assets fell by $60billion so Lehman reported their leverage ratio was now somewhere in the region of 12.5-1. However, the balance sheet was hiding a few details that actually shed a little light on how much trouble the firm was actually in.

The report from Valukas (2010) indicated that Lehman’s accounting department had been implementing a practice codenamed “Repo 105” within the firm. There is a slight difference between this and the standard repo operation of corporate firms. When an ordinary repo is performed, assets are sold to raise quick, liquid cash but it also comes with a concurrent obligation to repurchase the same assets within a very short period of time since the original transfer of funds. Repo 105 is performed in the same way but the assets are repurchased at 105% of the value that was paid for them originally. However, the main difference between these is how they are classified when publishing the quarterly returns. The assets transferred in a normal repo procedure remain on the firm’s balance sheet and are explained as “financings”. Repo 105 assets can be included on the balance sheet in the same way but it is no compulsory to do so. Accounting regulations allow for these particular assets to be treated as sales and, consequently, removed from the balance sheet. This procedure is an accounting manipulation that reduces net leverage on paper but not in reality.

Accounting trickery had taken place over a period of years. But it was during the final 3 quarterly reports that Lehman produced before bankruptcy that this procedure became of prime importance. At this stage as much as $50billion in the form of assets were being temporarily removed from the balance sheet to make their leverage appear lower than it actually was. It is evident that the only purpose of Repo 105 was to buy Lehman time with misleading information to continue operating in the hope that the situation could be rescued. The managers were fully aware that the firm was in trouble. Leverage and liquidity were recognised as the key factors. Continually, Lehman announced that they had enough liquid cash reserves to allow them to weather the financial storm and cover their liabilities, which was a lie because the majority of their reserves were illiquid. They wanted to the rating agencies to maintain their confidence in the firm, which in return will continue to be classified with the top security rating. In turn, this would encourage more buyers as Lehman would still be an attractive option.

Lehman didn’t disclose the use of Repo 105 to any other financial institutions, let alone the public. In fact, it was unclear who inside Lehman even knew of the “numbers massaging”. Richard Fuld himself overtly claimed that he wasn’t aware of the codename Repo 105, not to mention what the term referred to. Evidence found during Valukas’ investigation suggests otherwise. The Wall Street Journal, issued on March 11^th 2010, made clear that the executives at the top of Lehman had hidden the truth from their own board of directors, who would surely have objected to it.

In the aftermath it has become clear that the auditors of Lehman at the time, Ernst & Young, were fully aware of the implementation of Repo 105. They took no action upon discovering this. Ernst & Young were judged not to have met the professional standards expected of them. The Financial Times confirmed in December 2010 that Ernst & Young would face a lawsuit for their negligence and fraud. With 47 other complaints officially lodged against the accountancy firm at the time and several court cases already lost, this showed that they had previous form.

Accounting gimmicks, Repo 105 included, posed a serious risk to Lehman’s public image and overall professional reputation. Plain and simple, this was lazy banking. If anything, Repo 105 only exacerbated their problems in the long-term, plunging Lehman further into debt. When considering that the other option was to actually sell assets, reduce debt and meet leverage targets, Repo 105 was the easy way out on the short term loan market.

Subprime Mortgages: The Road To Ruin

As discussed in the previous post, Richard S. Fuld, Jr controlled Lehman Bros, instilling his own ambitions upon those working for him. Institutional Investor Magazine reported that at a company party on 7^th February 2005, Fuld showed his true colours in an address to his managing directors. Lehman shares debuted on the stock market in 1994 at a price of $8.00 (adjusted value) each. The end of day figure 11 years on was $92.70. The interim time period saw unprecedented growth. A conscious decision was made to pursue an aggressive market strategy some time in 2006 into a more capital intense banking model. All energies were focused on becoming the biggest player in Wall Street. To do so, the aim was in reaching a share price of $150 by 2007, but as he remarked:

“We have a problem. The problem is that now I can see 150. We’re getting close, and we need to raise the bar. So I want you all to think about how we get to 200.”

In a way this strategy was no different to any other investment bank. Lehman’s own model was not wholly unique, it was just a variation of how their competitors were generally organised. During the early-to-mid-2000s period, the mortgage market became a key element of Wall Street banking. Bankers found themselves dealing with securitised mortgages, summarised succinctly by the video at the bottom of the post. Lehman also got involved in this. It was viewed as a safer bet and profitable investment because of the strict approval process that was required for buyers to complete before they were allowed loans. This process required personal information about the buyer, including employment details and their income levels. A deposit of at least 25% the value of the house was also a prerequisite in some cases. These measures were needed to ensure that only a minority of mortgages were defaulted on. In any case that a default did occur, the recently purchased house would be used as leverage and would become property of the bank. This would help maintain the overall assets on their balance sheet, although their own cash reserves would become more illiquid. Thanks to the housing market this was proving to be successful. However, greed took over and the luck that the investors were experiencing desserted them.

A study conducted by Luigi Zingales (2008) highlighted that in the build-up to the subprime mortgage crisis, interest rates in the USA were set at a relatively low rate, and this had continued for a very long time. In turn, this lead to rising house prices for 9 consecutive years until 2006. The relative values of living over a 100 year period are indicated in Figure 1, taken from Robert Shiller (2005). This is interesting on the whole but our attention is drawn to the most recent era. Whilst interest rates and the cost of building remained fairly constant, the USA’s population grew steadily and house prices grew at an exponential pace.

It was also found that the loan delinquency rate dropped over the same time frame, which is the amount of loads that were defaulted on in comparison to the total amount of loans that were approved. Within the general population, confidence in the banking system was high and many more prosperous years were expected, as expressed in a survey by Case & Shiller (2005).

This proved to be a very profitable branch of their operations and investment banks saw an opportunity to make more money. The majority of those who qualified for a mortgage had already been approved and purchased their property. These earned large returns in interest due the sheer number of policies agreed. As a result, the mortgage brokers became more eager to lend because all of the risk involved was transferred to the purchasing bank. However, as the pool of possible customers dried up, so did the available profits. Therefore, they began to be more creative with the deals they offered to attract a larger portion of the public. A book by Schwartz (2009) claims this is when the lower quality adjustable-rate and subprime mortgages began to infect the market and pushed the boundaries of safe banking to the limits. This was a direct result of market regulations being relaxed.

Subprime mortgages are of particular significance. This is an alternative for borrowers with a lower credit rating. Effectively, these are riskier because the recipients of these loans are judged to be more likely to default on repayments. To reflect the higher level of risk involved, subprime mortgages are undertaken with a higher interest rate.

The idea of deflecting risk associated with mortgages was known as securitization. This was the practice of collating several mortgages together in a pool to be sold all together. Largely, there was very little monitoring of these deals, therefore, many types of mortgage were often grouped together whether they good or bad, prime, subprime or otherwise. There was further over-confidence with securitizations when the investment banks that agreed to buy them failed to perform their own quality checks. These blatantly obvious oversights meant that, more often than not, investment banks were in the possession of worthless and extremely risky securities, which were of considerably less value than they were credited as having.

Yuliya Demyanyk (2009) explains that the growth of the housing market was unsustainable and the quality of the mortgage loans had decreased year on year for nearly a decade. The risks that this brought were hidden by the excessive values given to properties at the time. This spelled trouble for banks when the level of defaults reached an all-time high and, consequently, the housing market bubble crashed in mid-2008. Now, investment banks, including Lehman, found themselves holding illiquid cash in the form of devalued housing. This deprives banks of the regular stream of money brought in by these investments, bringing on cash flow issues with their own loans to pay back and dividends to be issued to shareholders.

The examiner’s report into the Lehman Brothers Bankruptcy, conducted by Anton R. Valukas (2010), indicated that the management at the top of the firm were slow to recognize the crisis that lay ahead. The situation was grossly underestimated by Fuld and other executives, who didn’t think that it could infect other sectors within the market and it was too far gone by the time they finally took action. As they were aware that buyers would not be forthcoming, the decision was taken to “double down” with the mortgages the firm held. Akin to the blackjack strategy of the same name, it is a calculated gamble to hold on to mortgages already purchased in the hope that market conditions will improve again and will prove profitable. In a sense, Lehman was trying to weather the storm.

Essentially, the housing bubble bursting compounded the losses that Lehman had been accruing over last reported quarters. Their venture into housing assets had been funded by taking on loans with the interest offered by the held mortgages high enough to still turn a significant profit.

The video above, created by CrisisOfCredit.com, is a simplified version of events, which I think helps to explain how the subprime mortgage crisis came about and brought on the collapse of financial institutions including Lehman.